Let’s assume that you’re thinking about buying stock in West Coast Electronics. So far in your analysis, you’ve uncovered the following information: The stock pays annual dividends of $5.00 a share indefinitely. It trades at a P/E of 10 times earnings and has a beta of 1.2. In addition, you plan on using a risk-free rate of 3% in the CAPM, along with a market return of 10%. You would like to hold the stock for three years, at the end of which time you think EPS will be $7 a share. Given that the stock currently trades at $62, use the IRR approach to find this security’s expected return. Now use the dividend valuation model (with constant dividends) to put a price on this stock. Does this look like a good investment to you? Explain.
Required Ret = Rf + Beta ( Rm - Rf )
Rf = Risk free Rate
beta = Systematic Risk
Rm = Market ret
Required Ret = Rf + Beta ( Rm - Rf )
= 3% + 1.2 (10% - 3%)
= 3% + 1.2(7%)
= 3% +8.4%
= 11.4%
Price after 3 Years = EPS3 * P/E ratio
= $ 7 * 10
= $ 70
IRR is the Rate at which PV of Cash Inflows are equal to Stock Price today.
Year | CF | PVF @11% | Disc CF | PVF @12% | Disc CF |
0 | $ -62.00 | 1.0000 | $ -62.00 | 1.0000 | $ -62.00 |
1 | $ 5.00 | 0.9009 | $ 4.50 | 0.8929 | $ 4.46 |
2 | $ 5.00 | 0.8116 | $ 4.06 | 0.7972 | $ 3.99 |
3 | $ 5.00 | 0.7312 | $ 3.66 | 0.7118 | $ 3.56 |
3 | $ 70.00 | 0.7312 | $ 51.18 | 0.7118 | $ 49.82 |
NPV | $ 1.40 | $ -0.17 |
IRR = rate at which least +ve NPV + [ NPV at that Rate / CHnage in NPV due to 1% inc in DIsc Rate ] * 1%
= 11% + [ 1.40 / 1.57 ] * 1%
= 11% + 0.89 * 1%
= 11% + 0.89%
= 11.89%
IRR > Required Ret, Hence it is good Investment.
Let’s assume that you’re thinking about buying stock in West Coast Electronics. So far in your...
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